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When Elizabeth Warren, D-Mass., and John McCain, R-Ariz., get together, it gets noticed. In partnership with Sens. Maria Cantwell, D-Wash., and Angus King, I-Maine, they have introduced a bill, the “21st Century Glass Steagall Act,” notable both for its substance and as a call to action on one of the great unaddressed challenges of financial reform: the trend of accelerated concentration that has left us with an industry dominated by a handful of giant, multi-purpose, dangerously opaque and conflicted institutions far too caught up in speculative games to attend to their rightful job of supporting investment and entrepreneurship and broad prosperity.

Like its New Deal-era namesake, the bill would erect a wall between traditional banks and the risky world of investment banks and hedge funds. Their proposal updates the original law in thoughtful ways, by, for example, barring bank involvement in a range of dealer, trading and derivatives market activities, while preserving the ability of banks to engage in traditional trust and fiduciary roles.

21st century finance needs such a law for the same reasons 20th century finance did: to prevent bankers from using insured deposits and other taxpayer-supported advantages to enrich themselves; to reduce the conflicts of interest that encourage the mislabeling and overmarketing of high-risk investments; and to keep banks from leveraging their power and pivotal economic role to encroach on the territory of non-financial businesses or simply to overcharge their customers.

Wall Street has settled on a simple line of attack: Glass-Steagall, industry leaders and lobbyists insist, would not have prevented the financial meltdown of 2008. Indeed, the four Senators have not advertised their proposal as a magic bullet, eliminating the need for such measures as stronger capital and leverage rules and more transparent derivatives markets.

But there is a lot that it could do. Insiders without an immediate material stake in the question argue that a strong Glass-Steagall law could have limited the scope and damage of the meltdown, much as better compartments could have saved lives on the Titanic. Former Citigroup co-CEO John Reed, for one, believes “we would’ve hit the iceberg anyway,” but the flooding “might not have spread throughout the whole ship.”

The critics point out that pure investment banks such as Lehman Brothers and Morgan Stanley were in the vanguard of the bad practices propelling the financial system toward disaster. But the lines between commercial and investment banks had been badly eroded by decades of deregulation, spurring competition from commercial banks that helped drive investment banks into the dangerous business of making long-term financial commitments with deposit-like instruments and other kinds of short-term debt.

In any case, the rationale for this legislation goes beyond safety. It would gradually require the biggest banks to downsize along functional lines. By removing some of the artificial advantages of enormous size in finance, Warren-McCain-Cantwell-King would create new running room for institutions, including many community banks and credit unions, that have stuck to the old-fashioned model of taking in deposits and giving out loans – only to lose more and more business to the six megabanks, which now hold double the assets of numbers seven through 50 combined. And since small businesses often don’t get much respect from big banks, “Anything that tilts the playing field back toward smaller financial institutions is good for the small business sector,” Simon Johnson of MIT points out.

Like another bipartisan measure – the bill introduced by Sens. David Vitter, R-La.,and Sherrod Brown, D-Ohio, to set higher capital requirements for the biggest banks – Warren-McCain-Cantwell-Kingreminds us of a long lineage of free-market conservatives, going back all the way to Adam Smith, who have advocated strong regulation of the financial sector, not just because of its propensity for panics tending to cause wide and prolonged economic distress, but also because of its importance as an element of core economic infrastructure.

The original Glass-Steagall Act was a response to the specific misdeeds that produced the banking industry collapse of early 1933. But, in reining in an overly reckless and powerful industry, it bore the influence of a tradition of reform measures that, from the Interstate Commerce Act on, had required companies with a role in running the essential networks of the economy to stick to one line of business and provide even-handed service to all.

Under Glass-Steagall, banking became more boring and less profitable. The bankers of the 1930s didn’t welcome that prospect any more than today’s bankers do. But they lived with it, quite comfortably, for a long time, and so did the country as a whole. In fact, Glass-Steagall was part of a body of financial regulation that stands as one of the great success stories of American public policy, giving us half a century without major bank failures and contributing to a period of unprecedented growth and prosperity which saw the emergence of a middle class that was the envy of the world.

As banking becomes more boring again, we might just see a burst of enterprise and ingenuity where we really want it – in the real economy instead of the financial economy.

Americans have learned a lot in recent years about how our largest financial institutions make their money. But few would have imagined that a million and a half tons of aluminum – a quarter of the national supply at any given moment – typically sits in a network of 27 Detroit warehouses owned by Goldman Sachs. And hardly anyone would have thought that manufacturers seeking to purchase that aluminum might wait 18 months or more for delivery, while warehouse owners like Goldman Sachs collect additional rent, paid for by consumers of aluminum products ranging from beer cans to home siding.

In an important hearing yesterday before the Senate Banking Committee, Tim Weiner of MillerCoors described the operation and how it boosts prices for real-economy companies. The witnesses at yesterday’s hearing explained how the largest Wall Street banks have accumulated massive amounts of physical commodity infrastructure, ranging from warehouses to oil tankers to power generation plants.

Supply bottlenecks in bank-owned warehouses are only one part of the story. Banks are central players in the financialization of commodity markets, the treatment of physical commodities as purely financial assets to be manipulated for trading and investment purposes, rather than inputs for the real economy.

The original purpose of markets in commodities and commodity derivatives was to ensure steady prices and consistent availability for real-economy users of commodities. But the selling of commodities as an inflation hedge and a retirement asset (over $440 billion in investor money has poured into commodity investment funds since 2004, as opposed to just $25 billion into equity funds) has transformed these markets, increasing price levels and price volatility, and opening up many opportunities for manipulation.

Some of the richest opportunities for such manipulation lie in combining control of physical commodities with dominance of commodity derivatives and futures markets. The major banks are, of course, key dealers in these derivatives markets. Control of physical commodities allows them to both forecast and influence the spot commodity prices that can determine derivatives pricing. Indeed, some observers have pointed out that bank involvement in warehousing has allowed them to conceal information from the markets on the true supply of physical commodities, creating market squeezes and artificially fueling investor appetite for commodity futures.

Big financial players are constantly seeking new ways to take advantage of this nexus. For example, the Securities and Exchange Commission recently approved the applications of JP Morgan and BlackRock for exchange traded funds (ETFs) that will be backed by physical copper. These funds will store physical copper in bank-owned warehouses to back investor shares in the ETF – potentially creating an investor-funded squeeze in the physical copper markets that would raise commodity prices and make market manipulation easier.

The potential conflicts of interest and opportunities for manipulation created by the combination of a dominant position in derivatives markets and a dominant position in actual commodity infrastructure are one reason why the traditional division between banking and commerce makes sense. Banks have a central role in the economy, thanks to their key position in the financial markets, their enormous balance sheet resources supported by leverage levels available to no other industry and their privileged access to liquidity. Unless the scope of their activities is restricted, they have too many opportunities for abuse of market power. As law professor Saule Omarova testified yesterday, Americans have traditionally viewed “large aggregations of financial power in the hands of a few money trusts with great suspicion.” Such aggregation of power is the inevitable result of a failure to separate banking and commerce.

Regulators and legislators can and should take action to limit bank involvement in physical commodities:

With increased public scrutiny of the issue, the Federal Reserve announced last Friday that it will review and reconsider its 2003 decision on the scope of commodity activities that it defines as “complementary” to banking and therefore permissible for banks. Reconsideration should lead the Fed to place stricter limits on bank commodity activities.

Both regulators and Congress need to reexamine the interpretation and impact of the “grandfathering” provision in the 1999 Gramm-Leach-Bliley Act. Goldman Sachs and Morgan Stanley, who only converted to financial holding companies in 2008, will likely try to rely on this provision to argue that they should be allowed to continue commodity activities.

Regulators and Congress also need to establish clear responsibilities for preventing manipulation of physical commodity markets. Right now, it’s not clear who has this job. The prudential banking regulators do not see the integrity of commodity markets as part of their mandate, even though the institutions they regulate have enormous capacity to manipulate these markets. The Commodity Futures Trading Commission regulates commodity derivatives markets, but not the markets for physical commodities. The Federal Energy Regulatory Commission does regulate spot markets in energy, but not in other physical commodities. The Securities and Exchange Commission regulates securities markets but not commodity markets. And the Justice Department has generalized anti-trust authority to prevent abuse of market power, but lacks the depth of experience and resources to provide a consistent presence policing commodity markets. It’s crucial to get a cop on this beat.

This week marks an important step forward in the implementation of financial reform. On Monday, the U.S. became the first country in the world to require mandatory clearing of many derivatives contracts, a crucial protection in these previously unregulated markets.

But even as this crucial protection takes effect, Wall Street is mobilizing to create a back door escape route. Its goal is to prevent U.S. regulation of derivatives transactions by U.S. companies that are conducted overseas.

This loophole could strike at the foundations of financial reform. Almost every major financial scandal involving derivatives – from the collapse of Long Term Capital Management’s Cayman Island operations in the 1990s, to the bailout of AIG’s London-based trades in 2008, to JP Morgan’s recent “London Whale” trading losses – has involved derivatives transactions conducted through a foreign entity. Wall Street banks routinely transact more than half their derivatives through foreign subsidiaries. Through numerous avenues, including an important Congressional vote today, Wall Street is trying to create an “extraterritorial” loophole in derivatives regulation.

Derivatives are essentially bets on future financial moves. Prior to the crisis, the massive markets in derivatives (over $300 trillion in notional value in the U.S. alone) were essentially unregulated, and conducted as simple contracts between any two financial firms. There was almost no public transparency or regulatory oversight of firms’ derivatives books, and no assurances that firms could deliver on the bets they made. This was a major contributor to the financial collapse.

The Dodd-Frank financial reform law of 2010 brought these markets under regulatory oversight for the first time. Although implementation of the rules has been greatly delayed by heavy industry opposition, we are finally beginning to see some progress. As of Monday, the Commodity Futures Trading Commission requires most U.S. derivatives transactions to be conducted through centralized clearinghouses. Clearinghouses specialize in risk management and guarantee performance of the contract. Future regulatory actions should bring close to 90 percent of the market under mandatory clearing.

Wall Street lobbyists are pushing hard to undermine this progress by exempting foreign transactions. If they succeed, entities nominally based in foreign countries but active in U.S. derivatives markets will not have to comply with U.S. derivatives rules. This could potentially include foreign subsidiaries of U.S. banks, the numerous U.S. hedge funds incorporated in places like the Cayman Islands and subsidiaries of major foreign banks that are major dealers in the U.S. markets. Because derivatives markets are global and conducted electronically, a click on a computer keyboard is all it takes for a major bank to route any transaction through a non-U.S. subsidiary. But the risk can still return to impact the U.S. economy.

Industry opponents claim that the rules of foreign countries will protect us in these cases. But no country in the world is as advanced as the U.S. in regulating its derivatives markets. While the U.S. is actively bringing derivatives regulations on line, key elements of oversight are still at least a year away in Europe and elsewhere. And permitting foreign regulation to govern U.S. derivatives transactions would be dangerous in any case. It would create an incentive for global banks to transact their business through whatever jurisdiction has the weakest regulations – a “regulatory haven” to match the tax havens that international corporations already use.

Multiple efforts are underway to undermine international derivatives rules. In Congress, the House will vote today on HR 1256, a bill that would sharply limit the jurisdiction of U.S. derivatives regulators over transactions conducted in foreign markets. This bill is likely to pass the House, having gained the support of a large majority of the Financial Services Committee – but it’s still important for pro-reform forces to register opposition. There should be more resistance in the Senate, where six Senators led by Sen. Sherrod Brown, D-Ohio, recently sent a strong letter to regulators supporting effective international regulation of derivatives markets.

At the same time, both Wall Street and foreign regulators are pressing the Commodity Futures Trading Commission to step back from enforcing its rules overseas. The CFTC is scheduled to begin enforcement next month, on July 12, but industry is pushing for additional and perhaps indefinite further delays. While current CFTC chairman Gary Gensler is a strong supporter of effective regulation, other commissioners, led by Scott O’Malia, favor more delay.

Finally, industry and (astoundingly) some members of Congress are seeking to renegotiate U.S. financial regulations through secretive international trade negotiations, which could allow numerous new international exemptions to be added without any public accountability or oversight.

It’s crucial that these efforts do not succeed. After years of work to implement basic safeguards in the massive shadow markets that crashed the global economy, we can’t let Wall Street sidestep these protections simply by taking its business overseas.

Unregulated derivatives markets have been at the center of almost every major financial crisis of the past two decades, from the 1998 bailout of Long Term Capital Management to Enron to the catastrophic financial collapse of 2008. (A fuller list would include the implosion of Banker’s Trust and Barings Bank, the bankruptcies of Orange County and Jefferson County, and numerous more ‘minor’ scandals). Derivatives can allow almost unlimited exposure to speculative risks, and no financial regulatory regime can be secure as long as they remain unregulated.

But derivatives regulation is highly vulnerable to attack by industry lobbyists. The technical details can be complex, and are understood by few outside the industry. So it’s easy to disguise major loopholes as ‘technical amendments’ or ‘clarifications’, even if the changes would seriously weaken or even destroy the capacity to regulate derivatives. Adding to the problem, the agencies responsible for derivatives reforms – the tiny Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) — are comparatively small and, unlike the banking regulators, depend on Congress for funding.

Industry lobbyists are trying to capitalize on this vulnerability through a coordinated assault on derivatives reform. One element of this attack is the so far successful effort to deny adequate funding to the CFTC, a key derivatives regulator. Another is a set of bills currently working their way through the House.

This legislation is usually presented as minor technical or clarifying changes, but that’s far from the truth. For example, the “Swaps Jurisdiction Certainty Act” (HR 3283) would make a huge range of derivatives reforms almost impossible to enforce by allowing big banks to evade derivatives regulations any time they deal through their foreign subsidiaries. Major banks have hundreds and sometimes thousands of foreign subsidiaries, and currently do more than half of their derivatives business through foreign affiliates. So such evasion would not be difficult. HR 2586, also being presented as a minor clarification, would make it almost impossible to achieve a significant goal of derivatives reform — ensuring fair price competition and full customer transparency in derivatives dealing. Under HR 2586 regulators would be banned from enforcing basic price transparency requirements at new derivatives exchanges. These bills have passed the House Financial Services Committee with some bipartisan support.

Another bill, HR 3336, has already passed the house by a 312-111 vote. Sold as a technical amendment that would assist small business, it would in fact eliminate key oversight rules for banks doing up to $200 billion in interest rate derivatives, global oil companies who do swaps trading, and other big financial players. Two other bills – HR 2779 and HR 2682 – are somewhat less sweeping but still have the potential to create real weaknesses in derivatives oversight. That’s particularly true in the case of HR 2779, which bans any regulation of swaps between affiliated companies. This legislation has already passed the House with large majorities.

It’s striking that a number of these bills include such sweeping language that as originally drafted they would have made it difficult to enforce not just new reforms but even pre-2008 prudential regulations on bank activities. This made someone nervous enough that sponsors added ‘reservations of authority’ language stating that key banking regulators such as the Federal Reserve would not be bound by the legislation when enforcing longstanding banking laws. It’s possible that this made some regulators less worried. But of course it leaves in place the damage to new derivatives reforms. If pre-crisis regulation had been sufficient we wouldn’t have needed reform at all.

Opponents of reform hope to pass off these major loopholes as unimportant technical amendments and potentially win large bipartisan majorities in the House. Although House bills passed on a partisan basis receive little attention, the hope is that a bipartisan majority would force attention to these bills in the Senate. But even amended versions of some of these measures would represent a significant setback. Consideration of these bills is also intended to intimidate the regulators as they work to complete derivatives rules. The experts at the regulatory agencies are supposed to work in a non-political environment, but they are now under fierce pressure from industry lobbyists. We’ve already seen cases where industry lobbying severely weakened regulations between the initial proposal and the final rule. A show of force in Congress increases the political pressure.

Fortunately, this is a battle we can win. All that’s necessary to stop this assault in its tracks is for Congressional supporters of reform – as well as the Administration — to hold firm and speak out in support of the common-sense derivatives oversight regime passed in law, and give regulators time to implement it. A bill that passes by a relatively narrow or partisan majority in the House is likely to die unnoticed in the Senate. It’s disturbing to see legislators of both parties, even some who in the past have supported reform, signing on to some of these bills or indicating their willingness to support them with amendments that could leave dangerous provisions still in place. We need legislators to stand up for the public interest, defend the derivatives reforms in Dodd Frank, and to let regulators do their job of implementing them. Join AFR’s mailing list or contact us at info@ourfinancialsecurity.org to learn how you can help.

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